What market failure is
- Market failure happens when the free market leads to a misallocation of resources: too much or too little of something is produced.
Externalities
- Negative externalities are costs to third parties, such as pollution from a factory or noise from an airport.
- Positive externalities are benefits to third parties, such as education benefiting society or vaccinations protecting others.
- The free market overproduces goods with negative externalities and underproduces those with positive externalities.
Public, merit and demerit goods
- Public goods are non-rival (one person using it doesn't reduce it for others) and non-excludable (people can't be stopped from using it), such as street lighting and national defence. The free market won't provide them because people can use them without paying (the free rider problem).
- Merit goods, such as education and healthcare, are underconsumed because people don't realise their full benefits.
- Demerit goods, such as cigarettes and alcohol, are overconsumed because people underestimate their harm.
Government intervention
- Taxes (such as the soft drinks levy on sugary drinks) and regulation (such as emissions limits) reduce harmful activities.
- Subsidies and state provision (such as free schools and the NHS) increase beneficial ones.
- Information campaigns correct information failure. But intervention can fail, for example if taxes are set at the wrong level.
Key terms
- Market failure
- When the free market misallocates resources.
- Externality
- A cost or benefit to a third party.
- Negative externality
- A cost to a third party, such as pollution.
- Public good
- A good that is non-rival and non-excludable.
- Free rider problem
- People using a good without paying for it.
- Merit good
- A good that is underconsumed, such as education.
- Demerit good
- A good that is overconsumed, such as cigarettes.